The Volatility Index

Many investors have wondered whether extremely low or high readings in the Volatility Index (VIX) have always given a strong signal as to when the market may be nearing a bottom or top. A plot of the VIX versus the S&P 500 back to 1986 is shown below.

From what I can see the VIX was rather volatile from 1986-1990 especially when the market crashed in 1987. Then from 1991 through 1994 the VIX was pretty stable as the market traded nearly sideways.

Meanwhile as the market started to rally strongly beginning in 1995 the VIX gradually became more volatile again by 1997 and has continued to be volatile ever since with strong fluctuations both to the downside and upside. The question is will the VIX eventually transition to a less volatile environment like occurred in the 1991 to 1994 time period when the market began to trade sideways or will it continue to see more strong fluctuations in the future?

If we break down the past 15 years into separate time periods and start with the past 5 years there has been a fairly strong correlation between a rapid drop or rise in the VIX and a nearing market top or bottom. Some examples of nearing bottoms associated with a quickly rising VIX have occurred at points A, B and C and to a lesser extent at points D and E. Meanwhile as the VIX has approached a very low level a nearing market top has occurred at points F, G, H and I over the past 5 years.

Meanwhile from the period of 1991 through 1994 the market traded nearly sideways as the S&P 500 only gained about 75 points during that 4 year period. During this period of time the VIX was pretty stable and really didn't move strongly in either direction.

Looking further back from 1986 to 1990 the VIX was more volatile and did do a good job of signaling a nearing top before the market crashed in 1987 (point J) and also was at a fairly low level before the market sold off in 1990 (point K).

Meanwhile as the VIX spiked sharply higher (point L) with the market crash in 1987 this did help signal a nearing bottom which eventually led to a longer term up trend until the market peaked in the Summer of 1990.

Overall it looks like the VIX has been pretty useful since 1998 with all of the market swings to the downside and upside while in the early to mid 1990's it wasn't that useful as the market traded basically sideways. In the mid to late 1980's there were a few times when it was useful especially when the market was nearing a significant bottom or top.

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